1. Field of the Invention
The invention generally relates to financial forecasting and planning. More particularly, it concerns estimating the expected life of deposits, especially core deposits (a/k/a non-maturity deposits), at a financial institution, to ascertain the sensitivity of deposits to changes in variables determined outside the financial institution such as interest rate changes, and to forecast the behavior of deposits.
2. Description of the Related Art
Financial institutions take in different types of deposits and pay interest on those deposits while simultaneously purchasing assets and receiving interest on those assets. The profitability of a financial institution depends on its ability to earn higher interest rates on its assets than it pays for its deposits.
Generally, the longer the maturity of an asset the higher the interest rate paid on it. This creates a performance incentive for financial institution managers to buy longer maturity assets. Funding longer maturity assets with retail deposits presents special challenges, though. This is because balances in some types of deposits—so called “core deposits” (a/k/a non-maturity deposits) including categories such as NOW (Negotiable Order of Withdrawal), savings, checking and MMDA (money market demand accounts), are eligible to be withdrawn from the institution actually or virtually upon demand. If such deposits are used to buy longer maturity assets, a potentially serious asset and liability maturity mis-match is apparently created.
In fact, however, a substantial fraction of core deposits tend to stay in an institution for a period measured in years rather than in days or weeks. Thus, financial institutions can and do in a probabilistic sense use these deposits to fund purchases of long-term assets. However, such purchases are fraught with uncertainty given the unknown true maturity of the underlying deposits.
There have been three major types of efforts aimed at resolving the problem of determining the expected life of core deposits as well as numerous attempts to address parts of the problem. Possibly the earliest efforts involve regulators including the Office of Thrift Supervision (OTS), the Office of the Comptroller of the Currency (OCC) and the Federal Reserve (Fed). All these regulatory bodies have, at least in part in the interests of simplicity and fairness, adopted a “one size fits all” approach to considering the probabilistic withdrawal of core deposits.
The Fed has made its conclusions the most explicit of the three. For example, see David M. Wright and James V. Houpt, “An Analysis of Commercial Bank Exposure to Interest Rate Risk,” Federal Reserve Bulletin, (February 1996, pp. 115-28).
In contrast, the OTS has been the most secretive about its internal process which is essentially a black box to those outside the OTS, although notes released and Fed publications indicate that OTS and Fed procedures are very similar. The Fed's published work indicates that it has examined a cross-section of financial institutions and has estimated the average lives of all types of core deposits to be very short, typically less than five years, with checking accounts in particular having a life of approximately one year.
There are two problems with the approach of these regulatory bodies. First, they have been exceptionally conservative in their estimates of deposit lives, a finding not the least surprising given their regulatory roles. Setting short lives for core deposits increases the probability that a financial institution will not experience financial distress from excessive asset-liability maturity mismatch and thus cause problems for the regulator. The fact that this constraint may have major implications for profitability is not typically considered. Second, they have set an average life for a particular type of core deposit that does not vary across institutions. This unfortunately fails to address the issue that the different clienteles served in, say, a retirement community in Florida versus a suburb of Las Vegas, might cause dramatic differences in the behavior of deposits in those different local institutions.
The second general type of effort has been in the academic literature. An article by Richard G. Anderson, E. Jayne McCarthy and Leslie A. Patten, “Valuing the Core Deposits of Financial Institutions: A Statistical Analysis” in the Journal of Bank Research (vol. 17 #1, 1986, pp. 9-17) is perhaps the most complete and explicit statement of the process. Anderson et al. proposes sampling accounts at one institution on a yearly basis and then calculating what fraction of accounts remain with the institution from one to fifteen years later. The results in part address one limitation of the regulators' approach in that they consider only one institution rather than taking a cross-section of institutions at a point in time. The approach is to sample accounts at year-end and then consider the percentage of accounts remaining with the institution at year-end in subsequent years. The ratio of accounts (by account age) and the retention rate of accounts are calculated. This retention rate is then employed to estimate the economic value of the core accounts.
Nevertheless, this account sampling approach fails in at least two dimensions. First, it considers the number of accounts rather than the volume of funds in accounts. If larger accounts tend to remain with an institution while small accounts are more likely to be closed, this approach would seriously understate the value of a $1 in deposits. Second, there is no attempt to relate the retention rate to economic conditions, including interest rates or interest rate spreads. Anderson et al. fail to consider that both the number of accounts and the total balances of those accounts are related to interest rate differentials. For example, Anderson et al. do not take into account that, as an institution raises its rate relative to market rates, there might be a higher retention rate for deposits in retained accounts.
The third type of effort has been in the consulting area and is principally expressed in two publications. The first is by Z. Christopher Mercer, Valuing Financial Institutions (Homewood, Ill: Business One Irwin, 1992). In Chapter 19, “Branch Valuations and Core Deposit Appraisals,” Mercer presents what is likely the most explicit statement of the process of valuing core deposits. (In particular, consider Exhibits 19-3 through 19-8.) The methodology, however, is fundamentally the same as that in Anderson, et al. mentioned above and is subject to the same limitations.
The other statement of approach, labeled the Commerce Methodology, is briefly described in the American Banker, (May 3, 1996), N.J.'s Commerce Using High-Power Method to Evaluate Deposits and examined in more detail in Chapters 7 and 8 of Interest Rate Risk Models: Theory and Practice, by Anthony Cornyn and Elizabeth Mays (Editors), Glenlake Publishers, Chicago, London, New Dehli: 1997. That approach, developed by William J. McGuire and Richard G. Sheehan, the inventors, rectifies many of the difficulties with the approaches mentioned above. There initially is a survey of deposits, as with Anderson, et al. and Mercer, and that survey focuses on the total balances in the survey accounts. Those balances are then related to market rates including Treasury rates using regression analysis. The regressions yield simple linear relations between Treasury rates and prior retention rates. These linear relations then are employed to forecast retention rates for any time horizon and serve as the basis for valuing core deposits. The Commerce Methodology represents a dramatic improvement over all prior methodologies and has been subsequently employed for a number of financial institutions.
However, even the Commerce Methodology has limitations, in particular concerning the statistical specifications implicit in the methodology. That is, when retention rates are linked to other variables including Treasury rates, there remains a question concerning exactly which variables are to be included in the equation and how sensitive the results are to the particular equation employed or to the particular regression estimated. In addition, as with all conventional methodologies, the process of calculating the forecasted retention rates and their values is potentially dependent on the last few observations in the sample. That is, deposits are sampled monthly and if the last month indicates a sharp downturn in deposits, even though there may have been limited declines elsewhere in, say, a 48 month sample, the forecast may place more emphasis on that last month and to project that such a decline will become the norm in the forecasted period. The Commerce Methodology also has the deficiency as with prior methodologies that it restricts the relationships between variables influencing retention rates to be linear. There is no reason, however, why Treasury rate changes, for example, would necessarily influence a financial institution's deposits in a strict linear fashion. Finally, the Commerce Methodology does not allow asymmetries in relationships. That is, an increase in deposit rates and a decrease in deposit rates are treated as though they have the same impact (with the sign reversed) on the level of deposits. That procedure does not accommodate a case such as when a depositor may choose to keep deposits in an institution with a rate increase but may choose to leave with a rate decrease, for example.